/ 11 June 2003

SA’s deflation risk minimal

In a recent International Monetary Fund (IMF) Economic Forum on deflation, the IMF research department estimated that the risk of South Africa experiencing structural deflation was minimal, or less than 20%.

This assessment was based on data up to the end of March 2003 and prior to the May 30 downwards revision of consumer inflation data back to January 2002. Most economists expect the May 2003 data to show a m/m decline. The producer price index peaked at 127,8 in November 2002 and has been on a declining trend since then with the April 2003 index 1,1% below the November 2002 level.

Deflation can be caused by both demand and supply factors. Sharp falls in demand, reflecting a severe cyclical downturn, the bursting of an asset price bubble or excessively tight policies can result in declining activity and prices.

The alternative is a large supply shock that results in higher output, even while prices may be declining. This can reflect a variety of factors, including technological innovation and productivity growth.

Once prices start declining, expectations play a crucial role. Weakness in activity may be followed by increasing downward pressures on prices, reinforcing expectations about price declines in the future.

Deflation may not entail significant costs if it reflects temporary factors, such as declining import prices or an expansion in aggregate supply.

However, sustained deflation is seldom benign. It leads to a redistribution of income from debtors to creditors, depressing demand. Given inflexible wages, real wage costs rise, leading to declining profits and employment.

With the natural flow of zero nominal interest rates, the effectiveness of monetary policy is curtailed. This is of particular concern when output is weakening. And credit intermediation can be severely distorted as collateral loses value. The biggest concern, of course, is that a temporary period of declining prices develops into a sustained and self-enforcing deflationary spiral.

These effects are apparent from an assessment of historical episodes of deflation. The most extreme case was the worldwide deflation and the catastrophic collapse in activity in the late 1920s and early 1930s.

But even the milder deflationary episodes of the 19th century are not benign. Deflation was generally associated with rising debt burdens and bankruptcies, social and political unrest, financial crises and significant output volatility. More recently, the deflation in Japan has been associated with sub-par performance over several years.

The countries most at risk (more than 50% probability) are Japan, Hong Kong, Taiwan and Germany.

The IMF team said if 1% inflation is defined as the cut-off between deflation and inflation, then more than a fifth of both developed and emerging countries are currently experiencing deflation.

For most developed countries, the current deflationary bout is due to the bursting of the equity price bubble in March 2000 and the consequent downward pressure on both individual and corporate balance sheets.

For most emerging countries, the current deflationary bout is due to stronger currencies and lower oil prices. In Asia, the effect of severe acute respiratory syndrome (Sars) has seen a slump in tourism, which has in turn affected most service industries.

Most economists in South Africa agree with the IMF assessment that the deflation risk is minimal in South Africa, as wage increases are still running at the 9% level and the central bank has 1 300 basis points worth of interest rate cuts to work with, rather than the zero of the Japanese central bank, or the 125 basis points of the US Federal Reserve. – I-Net Bridge